Question

Book value versus market value components.

The CFO of DMI is trying to determine the​ company's WACC. ​ Brad, a promising​ MBA, says that the company should use book value to assign the WACC​ components' percentages. ​ Angela, a​ long-time employee and experienced financial​ analyst, says that the company should use market value to assign the​ components' percentages. The​ after-tax cost of debt is at 7.6​%, the cost of preferred stock is at 12.46​%, and the cost of equity is at 16.64%.

Calculate the WACC using both the book value and the market value approaches with the information

Current assets   $32,000 Current liabilities   $0

Long-term assets   $66,000 Long-term liabilities  
Bonds payable   $54,000
Owners' equity  
Preferred stock   $13,000
Common stock   $31,000
  Total assets   $98,000   Total liabilities and
   owners' equity   $98,000 

   Debt   Preferred Stock   Common Stock
Outstanding   54,000   130,000   1,240,000
Market Price   $936.56   $97.89   $32.45

. Which do you think is​ better?

What is the book value adjusted WACC for​ DMI?

​ (Round to two decimal​ places.)

What is the market value adjusted WACC for​ DMI?

​ (Round to two decimal​ places.)

Which do you think is​ better?  ​(Select the best​ response.)

A. The preferred choice is book​ value, which uses the original price of the debt or equity in the capital​ markets, the price at which investors currently buy or sell stocks and bonds. Book value represents the true capital structure of the firm based on the amount of capital originally invested in the firm.

B. The preferred choice is market​ value, which uses the current price of the debt or equity in the capital​ markets, the price at which investors currently buy or sell stocks and bonds. Market values are a better representation of a​ company's current capital​ structure, which would be relevant for raising new capital.

Answer 1

a). WACC = [wD x After-tax kD] + [wP x kP] + [wE x kE]

= [(54/98) x 7.6%] + [(13/98) x 12.46%] + [(31/98) x 16.64%]

= 4.19% + 1.65% + 5.26% = 11.10%

b). Market Value of Debt = Bond Price x No. of Outstanding Bonds

= 54,000 x $936.56 = $50,574,240

Market Value of Preferred Stock = Share Price x No. of shares outstanding

= $97.89 x 130,000 = $12,725,700

Market Value of Common Stock = Share Price x No. of shares outstanding

= $32.45 x 1,240,000 = $40,238,000

Total Market Value of the firm = Market Value of Debt + Market Value of Preferred Stock +

Market Value of Common Stock

= $50,574,240 + $12,725,700 + $40,238,000 = $103,537,940

wD = Market Value of Debt / Total Market Value of the firm = $50,574,240/$103,537,490 = 48.85%

wP = Market Value of Preferred Stock / Total Market Value of the firm

= $12,725,700/$103,537,490 = 12.29%

wE = Market Value of Common Stock / Total Market Value of the firm = $40,238,000/$103,537,490 = 38.86%

WACC = [wD x After-tax kD] + [wP x kP] + [wE x kE]

= [0.4885 x 7.6%] + [0.1229 x 12.46%] + [0.3886 x 16.64%]

= 3.71% + 1.53% + 6.47% = 11.71%

c). Option "B" is correct.